What Is Depreciation? How It Works and How Businesses Calculate It (2026)

August 18, 2026 4 Min Read

Depreciation is how a business spreads the cost of an asset over the years it gets used. It’s not claimed all at once, the moment it’s bought. A $15,000 van doesn’t get expensed in one hit. Instead, it gets written down a bit each year as it wears out and loses value.

That matters for two reasons. It gives a truer view of profit each year. In Australia, it also shapes what you can claim on tax.

Quick Answer

Depreciation spreads an asset’s cost across its useful life, rather than deducting it all at once. Firms use straight-line or diminishing value methods to work it out. Australian small firms, though, often use the instant asset write-off or the simple small business pool instead of standard depreciation schedules.

Why Depreciation Exists

Buy a laptop and use it for four years. It makes no sense to claim the full cost as an expense in year one alone. Depreciation matches the cost to the years the asset helps earn income. It also reflects reality: a five-year-old delivery van is worth less than a new one. Depreciation is simply how the books show that.

The Two Common Depreciation Methods

There are two standard ways to work it out. Each one produces a different pattern of deductions over time.

Straight-line depreciation spreads the cost evenly across the asset’s useful life. The formula:

Annual Depreciation = (Cost − Residual Value) ÷ Useful Life

A $10,000 machine with a $1,000 residual value and a 9-year useful life depreciates by $1,000 a year, each year, until it reaches residual value.

Diminishing value depreciation claims more in the early years and less later. That’s because many assets lose value fastest right after purchase. The ATO’s small business pool uses this approach by default: 15% in the first year, then 30% of what’s left each year after.

Neither method is “correct” on its own. Straight-line suits assets that wear evenly, like office furniture. Diminishing value suits assets that lose value fast early on, like vehicles and computer equipment.

What “Effective Life” Actually Means

Effective life is how long an asset is expected to keep earning income before it needs replacing. It’s not how long the asset will physically last. The ATO publishes effective life estimates for hundreds of asset types. Most firms use these instead of guessing.

A shorter effective life means faster depreciation and bigger deductions sooner. A longer one spreads the deduction out further. Businesses can also self-assess effective life in some cases. Still, sticking to the ATO’s published figures is simpler, and easier to defend if reviewed.

The Instant Asset Write-Off in Australia

Small firms with turnover under $10 million can often skip the depreciation schedule for lower-cost assets. Under the instant asset write-off, an asset costing less than $20,000 can be claimed in full in the year it’s first used. You don’t spread it out over several years instead.

Assets above that threshold go into the small business pool instead. They depreciate at 15% in the first year, then 30% a year after that. The government sets this threshold and the pool rates each year, so it’s worth checking the current figure before relying on it for a tax return.

Depreciation vs. Amortisation

These two often get confused, but they apply to different kinds of assets. The core idea, though, stays the same.

Depreciation applies to tangible assets: equipment, vehicles, buildings, machinery.
Amortisation applies to intangible assets: patents, licences, software, goodwill.

The underlying logic is the same either way — spreading a cost over the years an asset delivers value. The label just depends on whether the asset is something you can touch. That’s the whole difference.

Common Depreciation Mistakes

A few mistakes show up often in small business accounts:

Using the wrong effective life. Guessing instead of checking the ATO’s published tables leads to over- or under-claiming.
Forgetting the business-use portion. If an asset is used partly for personal reasons, only the business-use share can be claimed.
Missing the pool once over the threshold. Assets above the instant write-off limit still need tracking, just through the pool instead.
Not adjusting for disposal. Selling an asset you’ve already written down triggers a balancing adjustment. Record it — don’t skip that step.

FAQ

What is depreciation in simple terms?
It’s spreading the cost of an asset across the years it’s used, rather than claiming the full cost upfront.

What’s the difference between straight-line and diminishing value depreciation?
Straight-line claims the same amount each year. Diminishing value claims more in early years and less later, matching how many assets lose value fastest when new.

What is the instant asset write-off threshold in Australia?
$20,000 for eligible small businesses with turnover under $10 million, for the asset’s full cost, as of the 2025–26 year. Always confirm the current figure, since thresholds change.

Does depreciation affect cash flow?
Not directly. It’s a non-cash expense that reduces reported profit and taxable income, but no cash leaves the business when depreciation is recorded.

What happens to an asset once it’s fully depreciated?
It stays on the books at its residual value (often zero) until it’s sold, scrapped, or retired, at which point a balancing adjustment gets recorded.

Is depreciation the same as amortisation?
The concept is the same, but depreciation applies to physical assets while amortisation applies to intangible ones like software or patents.